David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Southwest Airlines Co. (NYSE:LUV) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Southwest Airlines Carry?
As you can see below, Southwest Airlines had US$2.45b of debt at June 2019, down from US$3.54b a year prior. But on the other hand it also has US$3.99b in cash, leading to a US$1.54b net cash position.
How Healthy Is Southwest Airlines's Balance Sheet?
According to the last reported balance sheet, Southwest Airlines had liabilities of US$8.61b due within 12 months, and liabilities of US$7.82b due beyond 12 months. Offsetting this, it had US$3.99b in cash and US$777.0m in receivables that were due within 12 months. So its liabilities total US$11.7b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Southwest Airlines has a huge market capitalization of US$29.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Southwest Airlines also has more cash than debt, so we're pretty confident it can manage its debt safely.
On the other hand, Southwest Airlines saw its EBIT drop by 2.1% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Southwest Airlines can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Southwest Airlines may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Southwest Airlines recorded free cash flow worth 67% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Although Southwest Airlines's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$1.5b. And it impressed us with free cash flow of US$2.9b, being 67% of its EBIT. So we don't have any problem with Southwest Airlines's use of debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Southwest Airlines's earnings per share history for free.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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